On April 13, 2015 Ontario's provincial government announced that it
will put a price on carbon emissions by joining
the cap-&-trade system that is already
used by Quebec and California. Ontario takes a different
path than British Columbia, which opted for a carbon tax in 2008.
The Q&A below sheds light on how a cap-&-trade works,
and how it is different from a carbon tax.

What is a cap-&-trade system?

In a cap-&-trade system, the government issues permits to
individual firms to emit a certain amount of carbon dioxide. In the
diagram below, these "allowances" are indicated by red
squares identical in size for both firms.
The firm on the left is very good at preventing carbon
emissions and as a result emits less than it received allowances
for. The firm on the right is rather poor at preventing carbon
emissions and ends up with more emissions than it has allowances
for. Now the left firm can sell its excess allowance to the right firm
that has excess emissions. When many firms trade
emission permits, a market price emerges that matches
supply and demand. More importantly, the emergin carbon price
ensures that all firms lower their emissions until the
cost of reducing an additional tonne of carbon
emissions reaches the carbon price. Firms
prefer abating emissions when this is cheaper than paying for extra
permits.

How are emission permits allocated?

With an emission cap, the government decides how much carbon
dioxide can be emitted in a given period in total. The tricky part is
to allocate fractions of the total cap to individual firms through
emission permits. There are two major ways in which this is done. One
method allocates permits through an initial auction. Firms bid for
permits, and the price at which demand and supply equal determines the
price. The revenue from selling permits goes to the governments. The
alternative is to give away the permits for free. This is called
"grandfathering". Firms receive free emission permits through an
allocation rule that is based on the firm's size, captured by measures
such as employment, sales, or value added. Of course, firms prefer
grandfathering over auctions because with a grandfathering system only
high-emission firms pay for permits, while low-emission firms gain
from selling excess allowances, and no revenue flows to the
government.

While most permits are auctioned, some emitters receive
free allocations from the Quebec government—those in
NAICS industries 212 (mining), 2211 (electric utilities), 22133
(air-conditioning supply), 31–33 (manufacturing of
food, beverages, textiles, wood and paper, chemicals,
plastics, metal, motor vehicles, etc.). However, the number
of free permits to these emitters are supposed to get reduced
progressively.

What happens with the revenue from Quebec's cap-&-trade system?

Quebec and California sell permits primarily through an auction.
The revenue from that auction in Quebec goes into the province's
Green Fund (fonds vert) that was created in 2006. Revenue
from that fund is supposed to be used to support activities
directed at fighting climate change, and thus
generate a double dividend. A double dividend occurs
when a carbon policy reduces carbon emissions, and revenue collected
through this carbon policy is used to help bring about further
emission reductions.

In British Columbia, revenue from the carbon tax is used to
reduce income taxes for corporate and personal income taxes. This
makes B.C.'s carbon tax revenue neutral. Quebec's system is not
revenue neutral, but revenue is meant to pursue a double dividend.
What will happen to Ontario's revenue has not been announced yet.

How does cap-&-trade differ from a carbon tax?

A carbon cap-&-trade system and a carbon tax differ in one
important way. A carbon tax provides a constant carbon price, while
the exact size of the emission reduction is not entirely certain.
A carbon cap-&-trade system provides certainty about the emission
reduction through the "cap", but the carbon price may fluctuate.
If too many permits are created, the carbon price may even drop
to zero. To prevent that from happening, the Quebec trading
system sets a price floor for the initial auction. Permits cannot
be purchased below the minimum price. Quebec's system of
cap-&-trade is therefore a hybrid approach that works
like a carbon tax should the market price fall below the price floor.

Is a carbon tax better than a cap-&-trade system?

Both a carbon tax and a carbon cap-&-trade system are
market-based instruments. Both offer the same level of short-term
efficiency as both equate marginal abatement cost and carbon
price. However, a carbon tax has one important long-term advantage: it
provides a predictable price, and this in turn provides a predictable
return on investment when businesses make investments into carbon
abatement equipment. The carbon price in a cap-&-trade system can
be quite volatile, as the E.U. Emission Trading System (EU-ETS) has
demonstrated. A carbon tax provides greater dynamic efficiency
over a cap-&-trade system. Nevertheless, a well-managed
hybrid cap-&-trade system with a price floor and price
ceiling can mimic the dynamic efficiency of a carbon tax. Wisely,
the California-Quebec carbon trading is such a hybrid system.

Isn't a carbon tax more transparent to consumers
than a cap-&-trade system?

A cap-&-trade system may look awfully complicated and
mysterious to non-economists. A tax is much easier to understand. However, with
both approaches the tax is mostly invisible to consumers, as
the carbon price is embedded in the aggregate price we pay
for goods and services.

Is a carbon tax cheaper to implement
than a cap-&-trade system?

With a carbon tax, the tax is imposed on the carbon embodied in
fossil fuels. Thus you pay a certain amount of carbon tax per litre of
gasoline at the pump. It becomes a little more complicated when
greenhouse gas emissions are not from burning fossil fuels but from
chemical or biological processes. With a cap-&-trade system,
emissions need to be either monitored, or one needs to keep track of
"inputs" (that is, fossil fuels). It is also possible to have
wholesalers pay for emissions associated with the eventual use of
their products. Thus, oil companies can be charged with buying permits
for the gasoline they sell to motorists, and utilities can be charged
with buying permits for the electricity they sell to households.

Auctioning emission permits actually has one advantage over
grandfathering permits—it reduces the amount of follow-up
trading among companies. Many companies will buy their permits
in the initial auction, and only need to engage in "fine-tuning"
during the course of the year.

Does Quebec's cap-&-trade system capture carbon
emissions from all sectors of the economy?

Some cap-&-trade systems (such as the EU-ETS)
only put a limit on carbon emissions from industrial sources,
but not households and transportation. The latter two typically
account for two-thirds of emissions in industrial societies.
However, it is possible to make a cap-&-trade system as
comprehensive as a carbon tax. As mentioned earlier, the trick
is to move the burden of obtaining permits up the supply chain
to the (big) companies that can more easily manage this.
It would be rather expensive and impractical
to ask individual households or motorists to buy individual
permits for their emissions. The transaction cost would be
prohibitive.

What carbon prices have emerged in
Quebec's cap-&-trade system?

Because Quebec's trading system is joint with California,
the market price is determined jointly. However, each jurisdiction
allocates a fixed amount of permits and receives a share of the
proceeds from selling the permits. The table below shows the
results from the first two rounds of auctions. In each round,
"current vintage" permits (for the current year) are sold
along with a smaller number of "future vintage" permits
(for 3 years in the future). Because the larger part of
the auction is transacted in US Dollars, the jump in the
minimum (reservation) price between the two auction rounds
is mostly due to the depreciation of the Canadian Dollar.
At a carbon price of about 15 CAD per tonne, it is about
half the level of the BC carbon tax.

Auction Round

Minimum Price[C$/t]

Market Price[C$/t]

Total Permits[Mt]

Quebec Permits[Mt]

Quebec's Revenue[mio. C$]

#1 – 20142014-11-25

12.82

13.68

23.071

1.049

14.35

#1 – 20172014-11-25

12.82

13.41

10.787

1.527

20.48

#2 – 20152015-02-18

15.01

15.14

73.611

11.172

169.14

#2 – 20182015-02-18

15.01

15.01

10.432

1.474

22.12

#3 – 20152015-05-21

14.78

15.01

76.932

13.118

196.91

#3 – 20182015-05-21

14.78

14.78

9.812

1.386

20.49

#4 – 20152015-08-18

15.84

16.39

73.429

11.171

183.09

#4 – 20182015-08-18

15.84

16.10

10.431

1.474

23.73

#5 – 20152015-11-17

16.16

17.00

75.113

11.172

189.92

#5 – 20152015-11-17

16.16

16.89

10.431

1.474

24.90

#6 – 20162016-02-17

17.64

19.50

68.026

11.150

217.43

#6 – 20192016-02-17

17.64

18.34

9.361

1.320

24.21

#7 – 20162016-05-18

16.40

16.97

7.260

1.085

18.41

#7 – 20192016-05-18

16.40

18.88

0.914

0.129

2.44

#8 – 20162016-08-16

16.45

18.59

30.021

3.520

65.44

#8 – 20192016-08-16

16.45

17.02

0.769

0.108

1.84

Prices in Canadian Dollars (C$).
Carbon emissions in million metric tonnes (Mt).
The column "auction round" describes the vintage year
for which the permits are issued along with the auction date.
This table may be updated after the original blog has
been published.

The numbers in the table above show that the market price
is barely above the reservation price. This indicates that the
price floor is critical. And—surprise—the cap-&-trade
is actually more like a carbon tax. Without the reservation price,
the market price would have likely been less. This means that
businesses do not find themselves in any difficulty of meeting
the carbon reduction targets. Another interesting feature of
the first two joint auctions is that the future price for the
2017 and 2018 vintage auctions is lower than the spot price for
the 2014 and 2015 vintage auctions. This means that businesses do
not expect the carbon price to rise significantly over time.

How will the carbon cap progress over time?

California's cap in 2013 was set at about 2 percent below the
emission level forecast for 2012, declines about 2 percent in
2014, and is scheduled to decline about 3 percent annually
from 2015 to 2020. Overall, California's Bill 32 targets a reduction
of 15% of greenhouse gas emissions by 2020 compared to the
"business-as-usual" scenario.

The cap-&-trade system in Quebec was launched in 2013 and was
linked to California's in 2014. Quebec aims to reduce greenhouse
gas emissions by 20% below 1990 levels in 2020. The program is
proceeding in two phases. The first phase (2013-14) includes only
large industrial emitters (>25 kt CO2 per year) and
electric utilities. The second phase (2015-20) expands the program to
distributors of fossil fuels, and the 2015 cap will reach about 85
percent of Quebec's total emissions. Quebec's emission caps for the
forthcoming years are shown in the table below.

Momentum is building for the California-Ontario-Quebec trading system.
In Canada, the trading system in Ontario and Quebec covers more than
half of our country's population. The liquidity of that market makes
it attractive for other provinces to join. Similarly, California's
environmental leadership role in the United States makes it likely that other
states in the US will adopt the California program rather than
design their own systems or adopt a different policy instrument.

The simplicity
of a carbon tax—and in particular the political attractiveness
a a revenue-neutral carbon dividend, discussed in my
July 31, 2014 blog—may yet
convince some jurisdictions to take another route. What matters at
the end of the day is that the carbon prices in different jurisdictions
are not too far apart. Large differences in carbon prices
across jurisdictions create economic distortions.

Where is the federal government in all of this?

The federal government is notably absent from any initiatives
to mitigate climate change. While provinces have unquestionably
jurisdiction over environmental matters and can pursue their
own environmental policies, the federal government also has
the power to initiate carbon policies. Curiously, the current
federal government that prides itself about being market-oriented
has only introduced command-and-control regulations that
are known to be less efficient than market instruments.
As a result of federal inaction, provincial governments will
continue to take the lead on climate change in Canada.

The Ecofiscal commission, chaired by my economist
colleague Chris Ragan of McGill University, has made four
sensible recommendations for implementing carbon pricing in Canada:

All provincial governments should move forward by implementing
carbon-pricing policies.

Provincial carbon-pricing policies—existing and new—should
increase in stringency over time.

Provincial carbon-pricing policies should be designed to
broaden coverage to the extent practically possible.

Provinces should customize details of policy design based
on their unique economic contexts and priorities; they should
also plan for longer-term coordination.

The last point in particular points to the need for
cooperation among the provinces and with US states.
A key question will always remain about the form of
revenue recycling, and here different provinces may
choose different routes.